United States Economy- The Fed May Go Bankrupt

United States Economy provides insight and analysis into the possible outcomes of current monetary and fiscal policy in the U.S.

It’s complicated. However, there are a few non-political analysts who are realists like us. Jim G. Rickards is one of those.

We’ve chosen to publish his entire article from King World News because he describes the Fed’s options brilliantly. If you have any savings, this article is crucial for you to read.

Jim’s analysis corroborates two independent conversations I had with members of two regional Federal Reserve Boards who attended the same conference I did back in July, 2010.

If the Fed stays the course or reverses course, high volatility and huge losses are with us. Read the article to understand why.

By James G. Rickards

“November 5 (King World News) – Disasters sometimes sneak up in small steps, each of which appears unthreatening at the time but which cumulatively spell collapse.

The Fed is leading the United States to ruin in ways that are claimed to be well intentioned and benign viewed in isolation but which take us finally into a locked room reminiscent of the Sartre play “No Exit.”

The Fed has finally embarked on QE2, the best publicized journey since the flight of Balloon Boy to which quantitative easing might well be compared.

Of course, quantitative easing, or QE, is just a euphemism for what is really going on. We’ll skip the Orwellian Newspeak of QE and stick to the Oldspeak – printing money.

How does the Fed print money? It’s easy; they simply buy bonds from the market and credit the seller’s bank account with electronic cash that comes out of thin air.

When they want to reduce the money supply, they do the opposite; that is, they sell bonds and the buyer’s bank account is reduced by the sale price and that money disappears.

So, printing money is just a massive program of bond purchases. The Fed intends to concentrate the current bond buying program in the intermediate sector of 5 to 10-year maturities.

As a result, the Fed is coming to resemble a highly leveraged hedge fund with an inverted pyramid of risky, volatile and junk debt balanced on a slim layer of capital.

Recall the Fed owns the Maiden Lane portfolio of junk from Bear Stearns and $1.4 trillion of mortgages whose value is in serious doubt because of strategic defaults, lost notes and halted foreclosures.

Treasury notes may be of good credit quality if you don’t mind getting paid back in debased dollars but even Treasury notes have market risk.

If interest rates go up, the value of Treasury notes goes down; it’s that simple. The Fed is taking both credit risk and market risk on its balance sheet in unprecedented amounts.

Right now the Fed’s balance sheet shows about $57 billion in total capital. Current assets are about $2.3 trillion. The current money-printing plan will take total assets above $3 trillion.

At that level, it only takes a 2% decline in asset values to wipe out the Fed’s capital. Put differently, it only takes a 2% drop in the average value of assets on the Fed’s balance sheet for the Fed to go bankrupt. And this is in an environment where various markets frequently go up and down 3% in a single day.

How risky is the Fed’s program of bond purchases? Very. For those who are not bond traders, here are a few quick pointers.

First off, intermediate term securities are more volatile than short-term securities. The Fed traditionally purchases Treasury bills of one-year or less in maturity.

Those bills are not volatile at all and don’t move much in price when interest rates change. So, mark-to-market losses are never that great.

But 10-year notes are highly volatile and losses can be huge in response to even modest increases in interest rates.

Secondly, with the Fed composing such a large part of the Treasury market, liquidity will decrease as fewer participants buy and sell each day due to the Fed’s dominant role.

This means bid/offer spreads will widen making it very costly for the Fed to unload their position if they want to. If the Fed is selling, who on earth wants to buy?

Finally, there is a concept called “DVO1” which is market jargon for the “dollar value of 1 basis point”. This is a measure of how much a bond goes down in price in response to a 1 basis point increase in interest rates. It happens that DVO1 is greater as interest rates are lower.

In other words, the decline in price of a bond in response to a 1 basis point increase in rates is greater when rates are at 1% than if they are at 5%. This element of volatility is independent of the fact that longer maturities are more volatile, so having longer maturities and a low-rate environment is like soaking C4 plastic explosives in nitroglycerine.

When critics raise the issue of mark-to market losses, the Fed has a simple answer, which is that they will hold to maturity. The Fed does not have to mark to market; they can simply hold the assets to maturity and collect the full proceeds from the Treasury or other issuers.

Just ignore for the moment the fact that some of the junkier assets and mortgages will not pay off, ever. That’s years away; for now, let’s just give the Fed the benefit of the doubt and say that mark-to-market losses don’t matter because they don’t have to sell.

Critics also raise the issue that this much money printing will result in inflation at best and maybe hyperinflation if velocity takes off due to behavioral shifts. The Fed is also very reassuring on this point.

They say not to worry because at the first signs of sustained and rising inflation they will reverse course and reduce the money supply by selling bonds and nip inflation in the bud.

But also note that the world in which the Fed wants to sell the bonds is also a world of rising inflation and therefore rising interest rates. This is the world of huge mark to market losses on the bonds themselves.

The Fed is saying don’t worry about mark to market losses because we will hold the bonds. The Fed is saying don’t worry about inflation because we will sell the bonds. Both of those statements cannot be true at the same time.

You can hold bonds and you can sell bonds but you can’t do both at once. You will want to sell when rates are going up but that’s when losses will be the greatest.

So the time when you most want to sell is the time when you will most want to hold. The Fed may say they can finesse this by selling shorter maturities only to reduce money supply and holding onto longer maturities.

But that just further degrades the quality of the Fed’s balance sheet and turns it into a one-way roach motel for highly volatile and junk assets.

So, here’s the bottom line on money printing, or QE if you prefer. If nothing happens, the whole thing was a waste of time.

If inflation takes off, the Fed will have to choose between holding bonds and letting inflation get worse or selling bonds and going bankrupt in the process.

Since no entity goes down without a fight, the Fed will naturally hold the bonds and let inflation take off. Do not ask about the exit strategy from QE; there is no exit.”